Investing Tip:
Six Questions About Mutual Funds
I went back over my investment tips recently and I realized I'd never given the six
questions to answer when researching a mutual fund. In order to answer these questions
go to Yahoo Finance and make
sure you have the symbol for your mutual fund. You can
then get answers to these questions:
- What is the fund turnover? Turnover shows how long the fund holds onto their
securities. So a 100% turnover means on average they sell all their stocks once a year.
Turnover below 40% is a good number for stocks (i.e. average holding period of 2 1/2 years).
After all, stocks are long term investments, so if they are keeping them just a few months
(turnover of 200% or so) then there may be something wrong with their strategy.
- What are the major holdings and do they match the 'style' of the fund? If a mutual
fund is supposed to be a conservative big cap fund but owns lots of biotech stocks,
they are engaging in 'style drift'. They are drifting away from the style the fund is
supposed to follow. This is a very common problem with mutual funds.
- What are the expenses? I've talked about this many times in the past, but generally
you want total annual expenses under 1.25%, including all loads and 12b-1 charges.
- How does the fund stack up against the S&P500? Click on the 5 year chart and click
the S&P500 button to compare it to the index. About 75% of stock mutual funds closely
track the S&P500. And if that's all they are going to do, why not just go into a low fee
index fund? Don't pay for active management that doesn't have a few original ideas. What
if your fund underperforms? That might be ok, because every dog has it's day and it might
be your fund's turn.
- Who is managing the fund? Is it an individual primarily or 'team' management? This
is an important question to answer because...
- What has been the fund's performance? This is the first thing that most people look
at, and sometimes the only information you get (for example) in your 401k plan at work.
Yet it's number 6 on our list. And if fact it mostly matters in light of number 5. If
it's a team managed fund, performance tells you very little. Different people make the
decisions, and a good year's performance may just be an up market, or mere chance.
But if a manager has run a fund for many years and has had good success (i.e. Peter Lynch)
then maybe the performance is meaningful because you have a sharp manager. Why doesn't
his matter more? Because stocks are not savings accounts with guaranteed returns. If you
looked at the eye popping returns on internet mutual funds in January of 2000 you might
have put all your money into them, and be broke today. Past performance is really
overrated, except as an indicator of a particular manager's acumen.
There are many other things you can research, such as learning about the quality of
the top holdings, Morningstar star ratings and how big is the fund (are they so large
they can't get out of their own way?). But if you answer the six questions above, you'll
have a pretty good sense about what your mutual fund is all about.
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Donald Steinmann and Advanced Financial Management assume no responsibility
for any actions taken due to comments made in The Investment Tip of The Week.